Business, Government, and the World Economy

Introduction

Economic Quiz

What is the current unemployment rate?How many people are currently unemployed?What is the size of US nominal GDP?What was the rate of growth of US GDP in 2nd quarter?What is the yield on 10 year Treasury Bonds?What is the amount of debt owed by US as a % of GDP?

Economics

What is Economics?

The study of the allocation of scarce resources

Macroeconomics

Interrelationship of Aggregate Economic Variables

Output (Gross Domestic Product)ProductivityThe level of prices (Inflation)Interest ratesEmployment (& Unemployment)Value of currency (Foreign Exchange)

Macroeconomic Goals

Providing JobsEconomic Growth

Increasing ProductivityIncreasing Standard of Living

Stable PricesOthers?

Basic Assumptions

Markets work in the long-run“Equilibrium” prices and quantities can be achieved.

Short-run constraints can inhibit long-run equilibrium

Speed of Market AdjustmentGovernment PolicyExogenous Shocks

Government Policy

Monetary PolicyControlled by Federal Reserve Board

Fiscal PolicyFederal and StateTaxes, Government Spending etc.

Trade PolicyTariffs, quotas, etc.

Regulatory PolicyEnvironmental, occupational safety, equal opportunity laws, minimum wage etc..

Microeconomics vs. Macroeconomics

Microeconomics - economic decisions faced by individual firms and individual consumers.Microeconomic decisions are based upon macroeconomic data as are macroeconomic policy decisions. There are the same underlying variables impacting both types of decision making – there has to be a link.

Common Questions

Microeconomics Macroeconomics

How much R&D will a firm undertake

How much leisure time do individuals desire?

How many I-Pods should Apple produce?

Will consumers save or spend? How much will the country save in aggregate?

What is the level of interest rates?

What is the current price level?

How can productivity be increased?

How can Output (GDP) be increased?

What is the current level of Unemployment?

Aggregating Micro?

Macroeconomics is not simply the aggregation of individual results

Fallacy of composition - not every individual acts the same way and even if they did the aggregate result may not reflect the individual result. For example, increasing nominal level of wages in an attempt to increase income…

Factors impacting the link between micro and macro

Rigidities – Macroeconomic relationships are often slower to respond to changes than individual marketsLiquidity – Short run decisions may not be based on long run expectationsKnowledge – Information is asymmetricExpectations - Assumed relationships may be impacted by expected changes, as opposed to current events.

Positive – What does occur under a given set of conditions – As prices rise demand falls.Normative – what should occur – includes judgment – how should income be distributed?

Positive vs. NormativeEconomics

Basic Economic Assumptions

Laws of Supply and DemandUtility MaximizationMarkets Forces Work in the Long Run

Ceterius Paribus“Other things being equal”

Multiple economic variables often change at any given time.Most economic models keep the variables not under consideration constant. Therefore looking at only the relationship between two variables will often produce inaccurate analysis.

Economic Theory Changes

Economic theory can change over time – even theory that is supported by empirical evidence Example: The Phillips Curve

1960’s Philips Curve

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Unemployment (Annual %)

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19611962

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19651964

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Monetary Policy 1960’s

Focus on money market conditions. Use of Free reserves as indicator resulting in procyclical monetary policy.

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Unemployment (Annual %)

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1970’s Phillips Curve ?

1996-2005 Phillips Curve?

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The Phillips Curve

Has been modified to look at expectations of inflation as opposed to the level of inflationTradeoff between inflation and unemployment is still a common discussion / stylized fact in the media and economic debates.

Measuring Economic OutputThe Key Variable: GDP

Gross Domestic Product The market value of all final goods and services produced in a country during a given time frame.

Components of GDPY = C + I + G + NX

Personal Consumption Expenditure (C)Items purchased by consumers

Gross Private Domestic Investment (I)Spending by business, construction, and inventory investment

Government Purchases (G)Total federal state and local government purchases

Net Exports (F or NX)Exports minus Imports

Personal Consumption Expenditures

Approximately 72% of GDP*Item % of

GDPDescription

Durable Goods 10% Goods that last > 3 yearsCars, appliances, furniture

Non-Durable Goods

20% Goods usable < 3 yearsFuel, food, clothes

Services 41% Intangible tasks by specialistsRepairs, hair styling, cleaning

www.bea.gov 1st qtr 2011

Gross Private Domestic Investment

Approximately 12% of GDP:Fixed Investment

Nonresidential (Structures and Equipment) Residential

InventoriesGDP should account for everything producedChange in inventories, is an important number to watch (not the level).

Government Spending and Net Exports

Government Spending: About 18% of GDPFederal - 7%: Defense vs. Non defenseState and Local 11%

Net Exports (Exports - Imports)Exports 11.6%Imports 14.3%.

Trends in GDP Components

Current Values1st Quarter 2010

Gross Domestic Product $14,597.7 Billion

Real Gross Domestic Product $13,216.5 BillionPercentage change from previous quarter (annual rate)2010 Qtr 2 2.4%2010 Qtr 1 3.7% 2009 Qtr 1 5%

Contributors to GDP1st qtr 2010

PositiveConsumption 1.15%Business Investment 3.14%

NegativeNet Exports -2.78%

Three Markets

Good MarketsConsumption, Business Investment, and Saving.

Asset MarketFinancial AssetsMoney

Labor MarketLevel of Employment and Wages

General Equilibrium

Adjustment of Interest Rates and Prices result in the Simultaneous Equilibrium of the Goods, Asset, and Labor Markets (general equilibrium). Interest rates and prices impact the amount of Government Purchases and Net Exports as well (and they also influence the equilibrium in each market)Therefore changes in any of the three markets can impact the level of GDP and the components of GDP.

Macro Interactions

GDPC+I+G+NX

Goods MarketConsumption, Saving, and

Investment

Asset Market

Government

Purchases

Net Exports / Interaction with Global Economy

Labor MarketWages and Employment

Interest Rates &Prices

Outline of the Class

Introduction (current state of the economy and the language of economics)Useful Mathematical ToolsLabor, Goods, and Asset MarketsGeneral Equilibrium (combining the three markets into one model of the economy)Applying and using the model to understand the economic environment and make better business decisions.

Goals of the Class

Students should improve their understanding of:

Basic theoretical macroeconomic models and the issues surrounding their usefulness.How macroeconomic performance is measured by commonly used economic indicators.How changes in macroeconomic performance relates to the theoretical models and therefore impacts decision making in the business world.

Some Basic Economic Language

Annual RatesRates of ChangeBusiness CyclesConsensus SurveyMoving AverageNominal vs. Real DollarsRevisions and BenchmarksSeasonal Adjustments

Economic Indicators

LeadingIndicators that move ahead of the total economy (ahead of GDP).

CoincidentIndicators that move with the level of GDP.

LaggingIndicators that move following GDP.

Capacity Utilization vs. GDP1967-2007

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-0.15

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GDP

The Current State of the Economy

The lingering effect of the financial crisisCauses of the crisisThe Great Recession

Current conditions - slowdown or double dip?

European Debt US deficit debateUS housing market

The Big Picture

Problems in Mortgage Market

Global Credit Crisis / Bank failures / Equity Losses

Declining Consumer Spending Decreased Business Investment

Who’s to Blame?

Economic Environme

nt Congress Consumers

Mortgage Originators Regulators Wall Street

GSEs Rating Agencies

International

Flows

How Financial Markets Enabled“Keeping up with the Joneses”

New Products

Poor Underwriting

Public Policies Unintended Consequences

Low Rates and International Capital Flows

Products

Underwriting

Policy

Markets

Mortgage Market Developments

Securitization and new participantsGraham Leach Bliley Financial Modernization Act of 1999Increased Use of Mortgage Brokers2000 Commodity Futures Modernization Act

Increased Access to CreditSubprime, Alt A, Option ARMs

Products

Underwriting

Policy

Markets

Securitization

Loan Bank B

Financial IntermediaryBuys Loans, Forms a “Pool”

and Issues MBS

Loan Bank A Loan Bank Z

Insurance Firm, Banks, Pension Funds etc.Buy MBS – Cash Flows “Guaranteed” by Original Mortgages

Products

Underwriting

Policy

Markets

Average Size of Subprime Loans

Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over

50% to total subprime

Products

Underwriting

Policy

Markets

Credit Quality of Subprime Loans Originated each year

Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,

over 50% to total subprime

Products

Underwriting

Policy

Markets

Structure of Subprime Loans Originated each year

Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,

over 50% to total subprime

Products

Underwriting

Policy

Markets

Impact of Subprime Loans on Home Ownership

"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007

Products

Underwriting

Policy

Markets

NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"

Fannie Mae’sGuarantee of Alt A Loans

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$ B

illions o

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2005$58

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2006$87

BillionAdded

2007$79

BillionAdded

2004 & Before$77 Billion Total

Products

Underwriting

Policy

Markets

Blaming Fannie and Freddie?

No - Fannie and Freddie were small relative to the entire market.

Combined Subprime Purchases (% of Market)**Consumer demand created rapid prince increase

Yes – Overall Size put them at risk for any Mortgage Market problem

Securitizing more risky loans opened door for Private securitization

Gramlich, E. "Subprime Loans: America's Latest Boom an Bust" 2007 ** "how HUD Mortgage Policy Fed the Crisis", Washington Post June 10, 2008

Products

Underwriting

Policy

Markets

International Capital Flows

Consumer Spending On Exports

Increased Foreign Holdings of $

Increased Inflow of Dollars Helps Keep Long Term Rates Low

Products

Underwriting

Policy

Markets

“The Perfect Storm” 2004 - 2007

Domestic and global institutions buy MBS in attempt to increase margins on “safe” securities, incorrectly rated.

Institutions use higher debt levels for securitization.

Underwriting standards deteriorate.

Increased interest rate environment makes loans more likely to default

Increasing Home Prices encourage consumers to overextend and speculate in housing market

Products

Underwriting

Policy

Markets

Home Sales and Home Prices

Non Agency Mortgage Foreclosure Rates

Response of Consumers

Increased access to credit and delusional optimism resulted in:

Short-Term Speculative FocusBorrowing More and Saving Less

Case Study: Natalie Brandon

1985 Buys $105,000 house 30 Year fixed rate loan Payment = $770

2000-2006Paid penalties to Refi 5 times in 5 years Yearly income = $100,000 2006 New Loan $625,500 2/28 7.99% teaserPayment = $4,585

Fall 2007Home Value = $450,000Attempt to Refi for 40 years at 6% Fails

Borrowing More & Saving Less

Equity Prices Compared to Past Recessions

Consumer Credit Outstanding Compared to Past Recessions

Impact of the Crisis

Increase in Precautionary Saving

Lost Wealth from Equity Declines

High Unemployment

Consumer Confidence hits Record Lows

Precautionary Saving

All Silents Boomers Gen X Gen YLess than 2 weeks 28% 11% 25% 31% 32%2 weeks to a month 22% 17% 21% 21% 27%2 to 3 months 22% 23% 24% 19% 22%4 to 6 months 14% 15% 11% 17% 12%7 months to a year 5% 7% 5% 6% 2%More than a year 10% 27% 14% 5% 6%

If you were to lose your job, for how long could you afford to be out of work and still meet your financial obligations including monthly expenses?

The 2009 MetLife Study of the American Dream

Confidence in Having Enough Money to Live Comfortably Throughout Retirement

Years

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“The Pressure I feel to buy more and better material possessions is greater than ever”

Metlife

26%

46%

10%

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18%

39%

29%

53%

47%

66%

74%

54%

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75%

82%

61%

71%

47%

53%

34%Gen 06

Y 09

Baby 06

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Silent 0609

Agree Disagree

Buyers Remorse

62%

79%

66%

54%

51%

38%

21%

34%

46%

49%

I have no regrets about the major purchases that I have made over the past few years

I regret making major purchases and wish I would have saved more over the past few years

Gen Y

Gen X

Boomers

Silents

All

The Crystal Ball – The Big Picture

How will Consumers Respond?Precautionary or Long Term Savings?Lost Faith in Investment Planning?View of home ownership

Corporate EarningsFinancial Markets and Regulation

Regulatory ChangesLong Term Inflation FearsMonetary and Fiscal PolicyInterest Rates

The Current State of the Economy

Slowdown or Double Dip?Federal Reserve PolicyFiscal PolicyGlobal Headwinds

Some Troubling Signs

Manufacturing

Consumer Spending / Confidence

Housing

Unemployment

Employment: Non Farm Payrolls

Employment: Non Farm Payrolls

Consumer Credit Outstanding

Consumer Credit Outstanding